Exchange-traded funds have been the investing world’s popular child for several years, intimidating some mutual-fund companies and beating out hedge funds in terms of attracting investor money.

But now the tradable index trackers may have turned off many investors with their so-called flash crash on the morning of Aug. 24.

As the Dow
DJIA, +0.33%
briefly dived by more than 1,000 points, or 6.6%, on that rough morning, big ETFs like the Guggenheim S&P 500 Equal Weight ETF
RSP, +0.41%
and the PowerShares S&P 500 Low Volatility ETF
SPLV, -0.15%
traded down by more than 40% at one point, disconnecting from the value of their stockholdings.

“It hardly instills confidence in that long-term, buy-and-hold investor when they see something like SDY trade off at a ridiculous discount to its underlying price,” said Ben Johnson, Morningstar’s director of global ETF research, referring to the SPDR S&P Dividend ETF
SDY, +0.41%

The wild swings on Aug. 24 by some of the biggest ETFs “certainly has left a dent in investors’ psychology” and “will make them think twice as it pertains to their choice of vehicle,” Johnson added. He recommends mutual funds that track indexes to anyone who can’t handle this recent “painful reminder of what the ‘ET’ in ETF stands for.”

Investors in mutual funds who were tracking their holdings that morning didn’t see them slide in the same dramatic way, as mutual funds are only bought and sold at day’s end.

No wonder they now look cooler, so to speak, and are getting positive press emphasizing how they can be less volatile. Meanwhile, exchange-traded funds are priced and traded throughout the day, and that’s in large part how they ran into trouble.

ETFs are “just a bundle of different securities, and each of these individual securities was trading at seemingly insane levels, tripping circuit breakers that were in place — which subsequently caused the ETFs to trade at even more insane levels and trip circuit breakers of their own,” Johnson told MarketWatch. “So what you saw was just this cascading effect.”

And before the market’s open, trading rules had resulted in a lack of data about stock-futures prices and no consistent indications for where many stocks might open. That is because S&P 500 futures had fallen sharply enough, as a Barron’s explainer noted earlier this month. Given the limited information, market makers in ETFs kept bid-ask spreads wide.

Don’t hate the player?

The turn of events has resulted in many analysts and ETF-industry insiders saying the so-called flash crash for ETFs was a market-structure problem.

Regulators and stock exchanges are now re-examining parts of the structure. They’re looking at rules aimed at aimed ensuring orderly trading — introduced after 2010’s Flash Crash — as some investors say the rules failed their first big test, a Reuters report said earlier this month. The Securities and Exchange Commission is poring over Aug. 24 trading data to see what might be done to dampen the big swings by ETFs, the report added.

“People should see it as a market-infrastructure issue, and the reality is that if a mutual fund was in the market trying to trade, they were impacted also. It’s just less transparent,” Deborah Fuhr, managing partner at research firm ETFGI, told MarketWatch. The financial industry “is looking at this and we all just need to wait and give them time to assess. And I don’t think it’s a long-term negative for ETFs because I do think at the end of the day, they do offer a lot of value.”

The bigger issue was that component stocks weren’t trading, said Chris Concannon, CEO of the BATS stock exchange. He told MarketWatch that about 50% of the S&P 500
SPX, +0.22%
wasn't open for trading on the New York Stock Exchange at 9:35 a.m. Eastern Time on Aug. 24.

There has been fresh debate among exchanges about the effectiveness of humans versus machines in handling moments of market volatility.

Anita Rausch, director of capital markets for ETF provider WisdomTree
WETF, +4.27%
sees ETFs as somewhat misunderstood after last month’s turbulence. “Some have tried to tarnish and blame the ETF structure for that day’s events. But in reality, this volatility event that led to a very brief liquidity event highlighted how dependent ETFs are on transparency,” she said in a recent blog post.

A separate problem last month obscured the value of holdings for hundreds of ETFs and mutual funds. It happened after a software upgrade at a large fund custodian, Bank of New York Mellon
BK, +1.28%
and it’s likely resulting in lots of headaches for the bank. But Morningstar’s Johnson views this “computer glitch” as “far less impactful” on ETFs, he said. Piling on, the Financial times, known for its skeptical views on ETFs, has suggested that volatility ETFs contributed to August’s market turmoil.

“In the grand scheme of things, this is a minor negative, but one that’s absolutely essential to be aware of,” Johnson told MarketWatch. The Morningstar researcher noted the ETF wrapper offers many “pluses” for investors. Often-touted benefits of ETFs include their low costs, transparency and the wide range of exposures available.

Mark Wiedman, global head of BlackRock’s
BLK, +3.39%
ETF business, stressed that one iShares ETF that was affected had “been out there trading great for 12 years,” as he discussed Aug. 24’s action with The Wall Street Journal. “It had 303 seconds where it didn’t function properly, where it was pricing bizarrely. You have to keep it in perspective,” he told the Journal.

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